27
Apr
10

WORKING CAPITAL DOES NOT EQUAL CASH FLOW


 

Working capital is often misunderstood for cash.  Working capital is the difference between all of your current assets (cash, accounts receivable, etc.) and your current liabilities (accounts payable, accrued expenses, etc.).  Notice that cash is actually only a part of this equation, and it is usually a smaller part at that.  So, what in the world is working capital?

working capitalThe easiest way to explain it is in terms of the number of days difference between when you pay for things and when you get paid.  Here is a simplified example:

Cash goes out to pay for parts and labor to build a widget.  After 10 days the widget is ready to be sold.  It takes another 20 days to sell the widget to a customer on credit (net 30 terms).  The customer pays early – in 25 days.  The total working capital cycle is 55 days.  Hence, the business needs to have enough “working capital” to fund this transaction until it gets paid. 

WORKING CAPITAL IS A CYCLE OF CASH FLOW

Based on the example above, a business will need a certain amount of “working capital” to handle this 55-day cycle.  But what if the company can improve its manufacturing process and get paid a little earlier, reducing its working capital days to 42?  This means the company would need less working capital to fund its operations.  Since most people confuse working capital for cash, we think a bigger number is better.  But companies that run an efficient working capital cycle require lower working capital, the sign of a well-run and efficient business.

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3 Responses to “WORKING CAPITAL DOES NOT EQUAL CASH FLOW”


  1. 1 Jason
    May 2, 2010 at 6:33 pm

    Paul, thanks for your input. Perhaps a simpler example to use would be the backbone of American, the farmer.

    The farmer’s cash flow cycle has usually only one period. In the offseason they need to buy seed, fertilizer, perpare the soil, ect. All this takes money and would require working capital until they can sell their crops in the spring and summer month.

    Most of my customers find the farmers cash flow cycle easy to understand.

    • 2 Paul
      May 3, 2010 at 12:38 am

      Jason, you’re truly welcome and thanks for your great insight. It is true, agriculture is the backbone of human civilization and the genesis of modern business and trade itself.

      Since a lot of modern farmers these days are under contract to harvest crops for large food companies such as Tyson, Pepsi Co, Kraft and Nestle, these farmers have made significant investments to keep their business running smoothly to meet their obligations. A trend I have seen on farm inflows is food company contract payments and government subsidy payments comprising the majority of the inflows from operating activities for these enterprises. Depreciation of equipment has been the largest expense considering the machinery is usually the largest investment.

      I also agree that the cash conversion cycle is of longer duration since many modern farmers only have one customer, the food company and this inventory cannot be converted until the crop is ready for harvest. So, this payable and capital will be tied up in the business process for a considerable amount of time until the seasonal receivables invigorate the rural businesses usually in a very timely manner.

      Unfortunately, in the agriculture business, it is extremely challenging to reduce working capital days since inventory must ripen in order to sell. This opens up a whole other conversation heading down the road of non-organic additives and hormonal additives in an effort to re-engineer a premium product and additional inflow. Let’s not go there but this is a serious issue being addressed as we speak. Remember, only purchase from free range, non-caged, organic happy animal farms. Bon appetit!


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